Guest blog post by Sebastiaan Wijsman, Economist at the KU Leuven Faculty of Economics and Business

Summary: Over the past four years, government deficits throughout the EMU have declined, but for some countries this is mainly due to decreasing interest rates. This hides the lack of real fiscal consolidation efforts, while it reduces the public call for improvement.

Consumption increases, jobs are created, and government deficits decrease. The European economy seems to recover and the European Commission predicts further improvement for the coming years. Nevertheless, we have to be careful, since under the surface there are some alarming developments. This blog post illustrates that the decreasing deficits are mainly due to decreasing interest rates and that there is therefore no reason for satisfaction. It camouflages the weak fiscal discipline, and even undermines the pressure to take sustainable budgetary measures.

The interest gift

First, consider the case of Belgium. The government’s deficit decreased the past years from 3% of GDP in 2013, to 2.2% in 2017. Accordingly, the danger area close to the 3% deficit ceiling as the European Union prescribes is left behind. However, this fiscal improvement of 0.8% is not at all an achievement of the Belgian government. We observe, contrarily, that the interest expenditures decreased strongly as well during this period and are responsible for the complete improvement of the government’s budget.

Between 2013 and 2017, the Belgian interest expenditures declined from 3.3% to 2.4% of GDP: a windfall of 0.9%. With this, it is responsible for the entire deficit decrease. This would not be a problem if the lower interest expenditures are a structural and sustainable improvement, for instance due to a lower debt level. Unfortunately, the debt level increased further during this period, while the real cause lies outside the government’s control: lower interest rates.

France and Italy

This is by no means a sole Belgian situation. Decreased interest expenditures polish the budget balances of several other euro countries as well. The figure below illustrates the camouflage effect for Belgium, France, and Italy – countries with debts higher than 90% of GDP. It depicts the decreases of deficits and interest expenditures between 2013 and 2017. The developments in Italy seems most alarming. Without the ‘interest gift’ the budget would not have been improved with 0.3%, but worsened with 0.6% of GDP. This would undoubtedly have led to a new Excessive Deficit Procedure. In France, 45% of the budget’s improvement is due to the lower interest expenditures. For all of these countries the debt level increased between 2013 and 2017.

Lower interest rates

The decreased interest expenditures are due to lower interest rates. While the Belgian government borrowed against an interest rate of 2.31% in 2013, this dropped to 0.15% in 2016. A similar decrease happened across the EMU. Through the lower interest rates, governments could borrow cheaper and use these funds to pay off older and more expensive loans. This improved budget balances artificially, as the European Commission and several national fiscal councils earlier warned for.

The lower interest rates are caused by several factors. First, investors consider government bonds in times of crises and low economic growth as safe haven for their money. Instead to invest in volatile shares, investors seek stability at government bonds which makes it cheaper for governments to borrow. Second, since March 2015 the European Central Bank appeared as large buyer of government bonds due to its quantitative easing. With this monetary tool, the ECB created about €1,600 billion by buying government bonds (among others) to drive up inflation and stimulate economic growth.

The sleeping pill

It is alarming that decreasing interest rates rather than governments’ fiscal policies are responsible for decreasing deficits. This camouflages the lack of real consolidation efforts, while it softens the public call for disciplined fiscal policies. The decreasing deficits are in that respect a very unwelcome present. The European economy recovers, there is reason for optimism, but early satisfaction can be devastating.

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